There are a wide variety of financial derivatives currently available in the market. In general, a financial derivative is a contract or financial product whose economic value can be derived from one or more other financial products.
One type of financial derivative is a financial futures contract such as a stock market index futures contract. Typically stock market futures contracts require cash settlement on the expiration date in an amount based on the reference stock market index. “Dow futures” are one example of a stock market futures contract, and use the Dow Jones Industrials index as the reference index.
Another type of financial derivative is referred to as a “swap”. One type of swap is referred to as an “interest rate swap”. In one variety of interest rate swap, one counterparty agrees to make fixed payments of interest to the other counterparty over a period of time (for example, five years) on a notional amount of principal. The second counterparty agrees to make payments to the first counterparty that fluctuate over the period of time in accordance with fluctuations in a “floating” interest rate (such as the LIBOR (London Interbank Offered Rate) 3 month rate). This type of interest rate swap is referred to as a fixed/floating interest rate swap. The period of time during which the swap is effective may be referred to as its “tenor”. The party that receives the fixed side of the interest rate swap may do so in order to hedge against future interest rate fluctuations. The party that receives the floating side of the interest rate swap may do so in order to speculate on future changes in interest rates. Interest rate swaps and other swaps may also be employed as part of financial strategies that are much more complex than simple hedging or speculation.
Another type of swap is referred to as a “credit default swap”. In a credit default swap, one counterparty agrees to make fixed payments (sometimes referred to as the “coupon”) to the other counterparty over the term of the swap on a notional amount of principal. The second counterparty in the credit default swap assumes a contingent obligation to make one or more payments to the first counterparty in the event that a “credit event” such as bankruptcy or financial default occurs with respect to one or more borrowers or issuers of debt obligations. The counterparty who receives the fixed payments is said to receive the fixed side of the credit default swap. The counterparty who stands to benefit in the event that the contingent obligation becomes payable is said to receive the floating side of the credit default swap. In some credit default swaps, the payment of the floating side is conditioned on the receiver of the floating side tendering, to the payer of the floating side, debt obligations issued by the referenced issuer (the “name”) in a face amount equal to the notional amount of the swap. Other types of credit default swaps do not include this condition for receipt of the floating side contingent obligation.
The party who receives the floating side of a credit default swap may do so for the purpose of hedging against credit risk of the reference name or names. The party who receives the fixed side of a credit default swap may do so for the purpose of speculating on changes in credit standing of the reference name or names. As in the case of interest rate swaps, credit default swaps may be employed in connection with much more complex financial strategies than simple hedging or speculation.
A credit default swap in which the floating side is contingent on occurrence of a credit event with respect to only one reference name may be referred to as a “single-name credit default swap”. Another type of credit default swap is defined in terms of a basket of names that are assembled into an index. A credit default swap of this type is referred to as a “credit default index swap”. One well known group of credit default index swaps is defined with reference to one or another of the “iTraxx” indices. A presentation entitled “iTraxx Europe CDS Indices—Series 7 (March 2007)”, downloaded from the website www.indexco.com, provides an example description (pages 13-15) of how a typical iTraxx credit default index swap operates. Another well known group of credit default index swaps is defined with reference to one or another of the Dow Jones CDX indices. The Dow Jones CDX credit default index swaps operate in a similar fashion to iTraxx credit default index swaps. (In a change of nomenclature, indices formerly known as Dow Jones CDX indices are to be known in the future simply as CDX indices, without the “Dow Jones” branding.)
In another variation, credit default index swaps may be defined in terms of “tranches”. Each tranche is defined by two percentages. The first percentage represents the “subordination level” and indicates what percentage of loss (if any) is borne by floating side payors of junior tranches. The second percentage represents the upper limit of the credit loss, as a percentage of the size of the underlying reference portfolio.
To provide a specific example of tranches in a credit default index swap, consider the “CDX NA IG” (CDX North America, Investment Grade) Series 8 index: Five tranches are defined for this credit default index swap: The most junior tranche (sometimes referred to as the “equity” tranche) is defined by percentages 0-3% and thus carries the risk of loss with respect to the first 3 percent of the reference portfolio. The next tranche is 3-7% and is referred to as the “junior mezzanine” tranche. The succeeding tranche is 7-10% (“senior mezzanine”), and the remaining two are 10-15% (“senior”) and 15-30% (“super senior”). To further specify the example, the floating payor of the senior tranche will only realize a principal loss if there are a sufficient number of defaults for the losses to exceed the subordination of 10% over the life of the tranche, and will lose all the principal when the losses reach the upper limit for the tranche (i.e., 15% of the portfolio).
As another example of tranches, for the iTraxx-Europe Series 7 credit default index swap five tranches are defined as follows: 0-3%, 3-6%, 6-9%, 9-12% and 12-22%.
The Eurex financial exchange has listed a futures contract based on the iTraxx Europe Series 7 index. According to the Eurex iTraxx futures contract, on expiration, settlement is to be made in cash according to a value fixed with respect to a particular iTraxx index as of the expiration date by the International Index Co. (IIC). IIC is the organization that generates the baskets and coupon rates for the iTraxx family of credit default index swaps.
There are certain problems that will be experienced with respect to credit default index swap futures contracts of the type listed by Eurex. For example, due to cash settlement, market makers in that type of contract will experience a large change in exposure on the expiration date, reducing the amount of liquidity they can bring to this futures contract. Moreover, there may be uncertainty as to the regulatory status of such a contract in the United States.